• Fixed Income

Sovereign interests: ESG matters in emerging market debt

The emerging market debt universe offers investors an expanding pool of opportunities that may be better assessed when integrating environmental, social and governance factors.

5 minute read

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Environmental, social and governance (ESG) factors are becoming increasingly relevant for investors in emerging market debt. Since the 2013 ‘taper tantrum’, a number of high-profile events indicate that sovereign ESG weaknesses can heavily influence the premium investors demand over risk-free assets to own emerging market debt (EMD).

In 2014, Russia’s annexation of Crimea and support of separatists in Ukraine sparked US and European sanctions, leading to higher borrowing costs not only for Russia but also some of its companies not subject to sanctions. In the same year, what began as a bribery investigation into the state-owned Brazilian energy company Petrobras would eventually ensnare politicians at the highest level, including ex-president Luiz Inacio Lula da Silva, and plunged the country in recession.

More recently, Turkey’s President Recep Tayyip Erdogan has consolidated his power base. After the opposition party candidate was elected the mayor of Istanbul in March, he pressured Turkey’s electoral board into annulling the results and a new election has been called in June. And, for the first time in a decade, Turkey slipped into a recession this year.

It is therefore unsurprising that risk analysis of the universe has evolved, and the traditional focus on sovereign or economic risks as the main drivers of EM bond spreads is no longer enough.

Institutional investors, in particular, are moving from tactical to more strategic EMD allocations. As part of this evolution, they are finding that a more methodical ESG integration process can be a valuable additional tool to consider alongside fundamental analysis when making investment decisions. 

Expanding investment universe

The opportunity set is expanding within EMD. Globally, the tradable asset class is about US$25 trillion, equivalent to a 16 per cent rise per year since 2000, according to Bank of America Merrill Lynch (see Figure 1).1 The majority is issued in local currency government and corporate bonds, with a smaller amount issued in hard currency.

All EMD debt categories are increasing in size. For example, the JP Morgan Emerging Market Bond Index – Global Diversified benchmark, which tracks hard currency EMD sovereign debt, had US$931 billion in total debt outstanding across 67 countries as of 31 December 2018, and increasing to 73 countries in 2019. In comparison, the same index had just US$263 billion across 32 countries at the end of 2006.

Figure 1: Total global emerging market debt outstanding

Rising ESG importance

Historically, investors have focused on fundamental variables such as the growth outlook, debt metrics and external sources of finance when analysing, for example, the credit spreads of sovereign bonds. While these remain relevant, evidence suggests ESG factors can play an important role in the risk-adjusted returns of EMD.

Mexico, for example, outperformed the JPM EMBI-GD index in 2018, but in the first quarter this year saw gross domestic product (GDP) unexpectedly fall by 0.2 per cent versus the previous quarter. Mexico’s growth momentum is softening at a time when its ESG fundamentals are also deteriorating. An indication of that can be traced to the new government under Andrés Manuel López Obrador (also known by his initials AMLO).

One of his first tasks as president was to severely reduce foreign participation in oil production and refinery with state-owned Petroleos Mexicanos (Pemex), Mexico’s largest employer and a significant contributor to the country’s annual budget. It is also the most indebted oil company in the world with US$106.5 billion of debt on its balance sheet, as of 30 September 2018. Without foreign participation, Pemex’s capital investments and annual oil output is expected to decline, potentially harming Mexico’s own financial position.

The Republic of Ghana, on the other hand, appears undervalued from a fundamental credit and ESG perspective. Fiscal and economic indicators have improved under the International Monetary Fund programme, which it entered in 2015 and completed in April 2019. The nation has cut its budget deficit and stabilised inflation, which stood at about nine per cent year-on-year as of January 2019.2 In comparison, year-on-year inflation was around 16 per cent in January 2015.3

In ESG terms, Ghana also has advanced, making improvements in areas such as government institutional strength, consistently free and fair elections – helped by press freedom – and higher quality infrastructure. Ghana is edging ahead of much larger emerging economies, including Mexico, in our proprietary ESG scorecard model. Yet investors can still take advantage of a wider Z-spread compared to Mexico. (see Figure 2).  

Figure 2: Z-spread vs. ESG score

Separation of E, S and G factors

While ESG factors have historically been incorporated indirectly into fundamental emerging market analysis, they are increasingly separated and considered on a stand-alone basis. This untangling the various strands of ESG drivers from other fundamental risk-return characteristics may help investors better understand risk-return patterns over time. Specific ESG variables impact performance in different ways, and so it is important to gauge whether they are material to returns and what the causality might be.

According to research by the United Nations Principles for Responsible Investment (UNPRI) initiative, governance has the highest correlation to credit spreads, followed by social and environmental variables.4 It is therefore unsurprising that governance often accounts for the highest weighting when calculating the overall ESG score of emerging market countries (see Figure 3).

Figure 3: E, S and G indicators in EMD

Because ESG scores are usually based on backward-looking data, however, a qualitative assessment of ESG trends is also needed to ascertain whether they are improving, stabilising or deteriorating. The impact of ESG risks can change over time, depending on the economic backdrop. In credit analysis, for example, a country’s budget deficit may not be a significant downside risk when growth is strong but could be a big threat as growth weakens. In the same way, ESG risks are not static. The risk of social protests may be higher during a recession than in a robust economy.

Stronger together

When individual E, S and G scores are combined on a weighted average to calculate a total ESG score for each country, there is often a slight improvement in the correlation between the total ESG score and the zero-volatility spreads (Z-spreads) compared to similar data using individual E, S and G scores.

The correlation between ESG scores and Z-spreads is about 55 per cent, lower than the 85 per cent correlation between credit ratings and Z-spreads, according to our analysis, as at 24 April, 2019. Nevertheless, ESG does appear to explain a significant proportion of the premium investors demand to invest in EMD.

There is also additional information from ESG variables not captured by sovereign credit ratings, such as institutional strength, gender equality and environmental health. Taking ESG factors into consideration helps investors better assess the risk-reward characteristics of emerging market bonds. 

Corporate co-dependence

Just as an emerging country’s credit rating impacts the price of its corporate bonds as well as its sovereign bonds, a country’s ESG score also affects both government and corporate EMD. Weak sovereign ESG scores could translate into weak corporate ESG scores; albeit company creditworthiness comes with its own set of ESG risks. Brazilian mining company Vale, for example, is facing increasing investor scrutiny about its ESG practices following two deadly dam bursts in November 2015 and January 2019, despite having a healthy balance sheet and strong growth prospects.5

The robust governance, strong social infrastructure and political stability that helps drive a nation’s economic prosperity and competitiveness is not merely contingent on government action but also corporate behaviour. When the ESG fabric of a country is strengthening, more active opportunities may arise for investors, whether at the sovereign or corporate level. The key for investors is to understand that the reverse is also true.


  1. Jane Brauer, ‘Size and structure of global emerging markets tradable debt,’ Bank of America Merrill Lynch, 30 July 2018
  2. Ghana’s inflation rate for January drops to 9 per cent,’ Government of Ghana, 19 February 2019
  3. ‘Inflation Rate Fell To 16.4 Per Cent in January’, Government of Ghana, 27 March 2015
  4. Shifting perceptions: ESG, credit risks and ratings,’ United Nations Principles for Responsible Investment, 2017
  5. ‘Vale surpasses expectations in 2018; can it spring a surprise in 2019 as well?’, Forbes, 1 April 2019


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